Impact of HFT on market quality and adverse selection - CFA

First Published 29th September 2015

Dr Svi Rosov, CFA

"There are concerns that high-frequency market-makers are so efficient at what they do that no other type of market participant can compete with them."

A new study by CFA Institute, Liquidity in Equity Markets:
Characteristics, Dynamics, and Implications for Market
Quality, finds that market quality is high,
trading costs are historically low, and liquidity supply is
generally resilient, dispelling some of the popular concerns
about the state of modern markets. However, a closer inspection
of market structure identifies the lack of diversity of liquidity
provision as a potential problem in the long run. The study also
suggests that a move toward enforcing larger tick sizes in the US
may undermine efforts to boost liquidity on lit markets.

Liquidity in Equity Markets
investigates two recurring investment practitioner complaints.
Firstly, the perception that contemporary market structure has
increased the "adverse selection" problem, whereby high frequency
traders (HFTs) divert their trading to dark venues during stable
market conditions, before switching to lit markets just as prices
begin to move. This often leaves investors using limit orders on
lit venues on the wrong side of the market.

Secondly, the study investigates the perception
that displayed liquidity does not represent the true ability to
execute trades. This may arise, for example, when HFTs post
numerous duplicate limit orders to increase the probability of
execution because they know that they have a speed advantage
which enables them to cancel the unnecessary duplicate orders
before execution.

Dr Svi Rosov, CFA, analyst, Capital Markets
Policy at CFA Institute and author of the study, analysed data
from 50 large and small cap stocks from the US, the UK and France
(150 stocks in total), looking at trading and quote data for
every stock on 48 days from 2010 to 2014. The study finds
evidence to suggest that participants on lit venues are adversely
selected against - in this case, picked-off by informed traders
when the quote rolls. This phenomenon is most evident in the US
where the proportion of off-exchange trading when the quote is
stable is almost double that of unstable periods. The report
argues that over time, this may erode the incentives to
participate on lit venues.

However, this finding should be considered in
the context of historically low trading costs in large cap
stocks. Small cap stocks suffer from higher trading costs, but
even these are low by historical standards. The study does not
find any evidence of systematic liquidity duplication across all
the markets which were analysed. Liquidity supply is generally
instantaneously replenished, suggesting the market is resilient
at the top of the order book.

Dr Rosov commented: "The data show that
spreads, be they relative, depth-weighted or effective, are at
historically low levels in the US, UK and France. In the US we
see spreads to as low as one tenth of their level in 1999 for
both large and small caps. Further, for large caps, the sizes
available at the top of the order book are roughly double what
they were in 1999. Small cap sizes, meanwhile, are little
changed.

"In the UK and France, since 2010,
depth-weighted spreads for a 25,000 GBP/EUR transaction have also
declined. It is hard to argue for wholesale changes to market
structure on this basis.

"Despite this seemingly rosy picture of modern
market structure, there are concerns that high-frequency
market-makers are so efficient at what they do that no other type
of market participant can compete with them. This makes the limit
order book more homogenous, with less diversity of liquidity
supply, which in turn means that there is an increased risk that
during times of stress, market liquidity can evaporate very
quickly."

Liquidity in small cap equity markets in the US
has been the focus of the Securities and Exchange Commission,
with a pilot study of larger tick sizes due to be implemented in
2016 to test whether larger spreads create incentives for more
market-making. Liquidity in Equity Markets suggests that
a larger tick size may amplify the incentives to trade
off-exchange by increasing the profitability of internalization
strategies and exacerbating adverse selection risk, thereby
imposing higher costs on investors.